Mean-Variance Optimization

Modern Portfolio Theory,

Markowitz Portfolio Selection
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Overview
The material presented here is a brief introduction to the concepts of
Mean-Variance Optimization (MVO) and Modern Portfolio Theory (MPT)
in both single and multi-period contexts. It is also intended to help you
decide which of the two MVO products, VisualMvo or MvoPlus, you
might consider for your investments.

Minimum-variance portfolio

Definition
Portfolio of stocks with the lowest volatilities (betas) and, therefore,
lowest sensitivities to risk. It makes maximum use of diversification to
achieve the resultant risk level that is lower than the individual risk level
of each of the stock it contains.
A portfolio of individually risky assets that, when taken together, result in
the lowest possible risk level for the rate of expected return. Such a
portfolio hedges each investment with an offsetting investment; the
individual investor's choice on how much to offset investments depends
on the level of risk and expected return he/she is willing to accept. The
investments in a minimum variance portfolio are individually riskier than
the portfolio as a whole. The name of the term comes from how it is
mathematically expressed in Markowitz Portfolio Theory, in which
volatility is used as a replacement for risk, and in which less variance in
volatility correlates to less risk in an investment.
Contents
1. Introduction

2. Single Period MVO

3. Multi-Period MVO

4. Which Product is Right for You?

5. References

1. Introduction
The fundamental goal of portfolio theory is to optimally allocate your
investments between different assets. Mean variance optimization
(MVO) is a quantitative tool which will allow you to make this allocation
by considering the trade-off between risk and return.

In conventional single period MVO you will make your portfolio

allocation for a single upcoming period, and the goal will be to maximize
your expected return subject to a selected level of risk. Single period
MVO was developed in the pioneering work of Markowitz.

In multi-period MVO, we will be concerned with strategies in which the

portfolio is rebalanced to a specified allocation at the end of each
period. Such a strategy is sometimes called Constant Proportion (CP),
or Constant Ratio Asset Allocation (CRAAL). The goal here is to
maximize the true multi-period (geometric mean) return for a given level
of fluctuation.

The material on multi-period MVO is largely based on the research

manuscript Diversification, Rebalancing, and the Geometric Mean
Frontier by William J. Bernstein and David Wilkinson [2].

2. Single Period MVO

Single period portfolio optimization using the mean and variance was
first formulated by Markowitz.

Markowitz Portfolio Optimization

The single period Markowitz algorithm solves the following problem:

Single Period Problem

• Inputs:
o The expected return for each asset
o The standard deviation of each asset (a measure of risk)
o The correlation matrix between these assets
• Output:
o The efficient frontier, i.e. the set of portfolios with expected
return greater than any other with the same or lesser risk,
and lesser risk than any other with the same or greater
return.

The efficient frontier is conventionally plotted on a graph with the

standard deviation (risk) on the horizontal axis, and the expected return
on the vertical axis. A useful feature of the single period MVO problem
is that it is soluble by the quadratic programming algorithm, which is
much less CPU intensive than a general non-linear optimization code.
This is the method implemented in VISUALMVO.

The Markowitz algorithm is intended as a single period analysis tool in

which the inputs provided by the user represent his/her probability
beliefs about the upcoming period. In principle, the user should identify
a number of distinct possible "outcomes" and assign a probability of
occurrence for each outcome, and a return for each asset for each
outcome. The expected return, standard deviation, and correlation
matrix may then be computed using standard statistical formulae.

More informally, the expected return represents the simple (probability

weighted) average of the possible returns for each asset, and the
standard deviation represents the uncertainty about the outcome. The
correlation matrix is a symmetric matrix, with unity on the diagonal, and
all other elements between -1 and +1. A positive correlation between
two assets A and B indicates that when the return of asset A turns out to
be above (below) its expected value, then the return of asset B is likely
also to be above (below) its expected value. A negative correlation
suggests that when A's return is above its expected value, then B's will
be below its expected value, and vice versa.
Two asset example

The basic principles of balancing risk and return may already be

appreciated in a two-asset portfolio. Consider the following example:

Correlation matrix
Expected Standard
Asset
return deviation
Asset 1 Asset 2

Asset 1 10.0% 10.0% 1.0 -1.0

Asset 2 13.0% 30.0% -1.0 1.0

In the two-asset case, the optimizer is not really necessary; all that is
required is to plot the risk and return for each portfolio composition. The
actual output presented here is adapted from that of VISUALMVO (the
dotted portion of the curve, and the labeling of the percentage of Asset
2 in portfolios A through E have been added).

Looking at the input data, it might appear that the small excess
expected return (13% rather than 10%) of Asset 2 does not justify the
considerable extra risk (a standard deviation of 30% rather than 10%).
But the following MVO diagram paints a different picture.

We see that as we start from

Portfolio A (100% Asset 1) of
the plot and begin to include
some Asset 2, not only does
the expected return increase,
as we would expect, but the
risk actually decreases until
we reach Portfolio B at 25% of
Asset 2. This "minimum
variance" portfolio actually has
zero risk (this is possible
because the assets are
assumed to be 100%
negatively correlated).

The efficient frontier runs from Portfolio B, the minimum variance

portfolio, to Portfolio E, the maximum return portfolio. The investor
should select a portfolio on the efficient frontier in accordance with
his/her risk tolerance.

Note that the maximum return portfolio consists 100% of the highest
returning asset (in this case Asset 2). This is a general feature of single
period mean variance optimization; while it is often possible to decrease
the risk below that of the lowest risk asset, it is not possible to increase
the expected return beyond that of the highest return asset.

Input Data Issues

A major issue for the methodology is the selection of input data, and
one possibility for generating the MVO inputs is to use historical data.
The simplest way to convert N years of historical data into MVO inputs
is to make the hypothesis that the upcoming period will resemble one of
the N previous periods, with a probability 1/N assigned to each.

The use of historical data provides a very convenient means of

providing the inputs to the MVO algorithm, but there are a number of
reasons why this may not be the optimal way to proceed. All these
reasons have to do with the question of whether this method really
provides a valid statistical picture of the upcoming period. The most
serious problem concerns the expected returns, because these control
the actual return which is assigned to each portfolio.

Failure of underlying hypothesis

When you use historical data to provide the MVO inputs, you are
implicitly assuming that

• The returns in the different periods are independent.

• The returns in the different periods are drawn from the same
statistical distribution.
• The N periods of available data provide a sample of this
distribution.

These hypotheses may simply not be true. The most serious

inaccuracies arise from a phenomenon called mean reversion, in which
a period, or periods, of superior (inferior) performance of a particular
asset tend to be followed by a period, or periods, of inferior (superior)
performance. Suppose, for example, you have used 5 years of historical
data as MVO inputs for the upcoming year. The outputs of the algorithm
will favor those assets with high expected return, which are those which
have performed well over the past 5 years. Yet if mean reversion is in
effect, these assets may well turn out to be those that perform most
poorly in the upcoming year.

If you believe strongly in the "efficient market hypothesis", you may not
believe that this phenomenon of mean reversion exists. However, even
in this case there is need for caution, as discussed in the next two sub-
sections.

Error in the estimated mean

Even if you believe that the returns in the different periods are
independent and identically distributed, you are of necessity using the
available data to estimate the properties of this statistical distribution. In
particular, you will take the expected return for a given asset to be the
simple average R of the N historical values, and the standard deviation
to be the root mean square deviation from this average value. Then
elementary statistics tells us that the one standard deviation error in the
value R as an estimate of the mean is the standard deviation divided by
the square root of N. If N is not very large, then this error can distort the
results of the MVO analysis considerably.

The true long term return

Suppose you believe that neither of the previous two problems is too
serious. Then you will also believe that if you apply the MVO method in
period after period, then the inputs which you use in each period will be
more or less the same. Consequently, the outputs in each period will
also be much the same, and so, by repeatedly applying your single
period strategy, you will effectively be pursuing a multi-period strategy in
which you rebalance your portfolio to a specified allocation at the
beginning of each period.

It is then reasonable to hope that the expected return given by the

Markowitz algorithm for your chosen portfolio will be the return that
would actually have been obtained by this rebalancing strategy in the
past, and thus also, by hypothesis, in the future. Unfortunately this is not
the case; the expected return assigned by the algorithm to each
portfolio is always an over-estimate of the true long term return of the
rebalanced portfolio. Since this discrepancy increases as the standard
deviation of the portfolio increases, the Markowitz efficient frontier
always exaggerates the true long term benefit of bearing increasing risk.
The moral here is to be wary of the rightmost part of the curve.

It is sometimes believed that this discrepancy is due to the fact that the
single period MVO algorithm does not consider rebalancing. This is not
correct; the origin of the problem lies entirely in the distinction between
the arithmetic and geometric mean return. The problem can only be
resolved by an extension of MVO into a multi-period framework (see
Section 3).

Summary

The above discussion does not mean to imply that the Markowitz
algorithm is incorrect, but simply to point out the dangers of using
historical data as inputs to a single period optimization strategy. If you
make your own estimates of the MVO inputs, based on your own beliefs
about the upcoming period, single period MVO can be an entirely
appropriate means of balancing the risk and return in your portfolio.

3. Multi-Period MVO
As we have seen, a major deficiency of the conventional MVO algorithm
in a multi-period context is that, when used with historical data, the
expected return which is assigned to each portfolio does not represent
correctly the actual multi-period return of the rebalanced (or for that
matter the unrebalanced) portfolio.

We begin our discussion of multi-period MVO by considering the

analysis of historical data.

Two Asset Example

Consider the following two-asset, two-period example:

1996 1997 Arithmetic Geometric Standard

Asset
return return mean mean deviation

Asset 0.0% 20.0% 10.0% 9.54% 10.0%

 1

Asset
43.0% -17.0% 13.0% 8.94% 30.0%
2

It is easy to check that under the hypothesis that the upcoming period
will resemble 1996 or 1997, each with equal probability, this data leads
to the MVO inputs considered in the single period two-asset example
above. As in the single period case, the optimizer is not really required
here; all that is necessary is to plot the risk and return for each
rebalanced portfolio composition. The actual output presented here is
adapted from that of MVOPLUS (the dotted portions of the curve, and the
labeling of the percentage of Asset 2 in portfolios A through E have
been added).

Comparing this plot with the

single period one, we see
some notable differences. The
returns of all the portfolios are
considerably smaller, and
Asset 2 has a lower geometric
mean than Asset 1, whereas it
had a higher arithmetic mean.
Nevertheless, as we increase
the allocation of Asset 2 from
0% at Portfolio A, the
geometric mean of the
rebalanced portfolio increases,
as did the arithmetic mean.

More significantly, we see that the rebalanced portfolio with the highest
geometric mean return, which occurs close to Portfolio C, has a return
of around 11.0%, which is considerably higher than that of either of the
two individual assets.

This is very different from the single period case, in which any portfolio
expected return must always lie below that of the asset with the highest
expected return. This enhanced geometric mean is only possible
because of the rebalancing; without rebalancing it is impossible to
obtain a geometric mean return higher than that of the highest
geometric mean return asset.

Lastly, we see that portfolios to the right of the maximum at 50%

composition have increasing risk and decreasing return; this feature is
not seen in the corresponding single period analysis.

Multi-Period Optimization with Historical Data

When generalized to multiple assets, the most natural problem to

attempt to solve with historical data is

Multi-period Problem A

• Input:
o The full historical data set
• Desired output:
o The Geometric Mean Frontier; i.e. the set of rebalanced
portfolios with greater geometric mean return than any other
with the same or lesser standard deviation, and lesser
standard deviation than any other with the same or greater
geometric mean return

This is a mathematically well posed optimization problem, which may be

solved exactly using the optimization capability of various spreadsheet
programs. However:

• It is a CPU intensive calculation, not soluble by quadratic

programming methods.
• It is not useful for forecasting, unless you believe that you can
predict the complete set of returns in every period, for some future
time interval.

Let us rather consider the following problem, which requires a less

extensive set of inputs.

Multi-period Problem B

• Inputs:
o The geometric mean return of each asset
 o The standard deviation of each asset
o The correlation matrix between the assets
• Desired output:
o The Geometric Mean Frontier; i.e. the set of rebalanced
portfolios with greater geometric mean return than any other
with the same or lesser standard deviation, and lesser
standard deviation than any other with the same or greater
geometric mean return

Unfortunately, Problem B is not easy to solve. In fact it is not even

completely well posed, because the input data do not uniquely
determine the geometric mean return of any given rebalanced portfolio.

A clue to finding an approximate solution to Problem B is to consider the

analogous problem with arithmetic means:

Multi-period Problem C

• Inputs:
o The arithmetic mean return of each asset
o The standard deviation of each asset
o The correlation matrix between the assets
• Desired output:
o The Arithmetic Mean Frontier; i.e. the set of rebalanced
portfolios with greater arithmetic mean return than any other
with the same or lesser standard deviation, and lesser
standard deviation than any other with the same or greater
arithmetic mean return

This problem is exactly soluble by quadratic programming methods. In

fact, it is already solved by the standard single period MVO algorithm!

This is because when we assume that the single upcoming period will
resemble one of the previous N periods, each with equal probability,
the expected return and standard deviation which are assigned to any
given portfolio allocation are precisely equal to the arithmetic mean and
standard deviation of the portfolio which was rebalanced to the specified
mix at the beginning of each period.
This exact mathematical result provides the conceptual link between the
single and multi-period versions of MVO.

Attempt to Solve Problem B

One popular attempt to solve Problem B is to retain the standard

Markowitz algorithm, but to use as return inputs for the individual assets
not the arithmetic means of the yearly returns, but rather the geometric
means. Unfortunately, this apparently plausible approach lacks any
mathematical validity.

Firstly, just as the Markowitz algorithm with arithmetic mean inputs

always overestimates the true return of any given rebalanced portfolio,
the same algorithm using geometric mean inputs always
underestimates the true return.

Secondly, the algorithm still produces a maximum return portfolio

consisting of a single asset (in this case the one with the highest
geometric mean), while we have seen in the above two-asset example
that the rebalanced portfolio with the highest geometric mean return is
sometimes a mixture of the assets.

Lastly, and most important, the weighted geometric mean does not
represent any meaningful property of the rebalanced (or unrebalanced)
portfolio with the given composition, while the weighted arithmetic mean
does at least correctly represent the arithmetic mean return of the
rebalanced portfolio.

A Better Solution

A much better way to solve Problem B is to exploit the existence of

approximate relationships between the arithmetic and geometric mean.
The mathematical foundation of the method is explained in Reference
[2].

The essential idea is to use the relationship between the arithmetic

mean and geometric mean to convert a Type B problem involving
geometric means into a Type C problem involving arithmetic means. At
the end of the calculation, the inverse relationship is used to convert the
portfolio arithmetic means back to geometric means. This is the method
used in MVOPLUS.
An important feature of the methodology is the fact that, to a good
approximation, the set of portfolios which optimize the rebalanced
geometric mean are the SAME as the ones which optimize the
arithmetic mean. This makes it possible for MVOPLUS to display a
combined plot of the Arithmetic Mean Frontier and the Geometric Mean
Frontier.

The actual relationship between the arithmetic and geometric mean

used in MVOPLUS is different from those described in Reference [2],
though the differences are small unless the assets are very volatile.

A solution to Problem B is only useful if it can be shown to provide a

reasonable approximation to the solution of Problem A when full
historical data is available; this is demonstrated empirically in Reference
[2].

MvoPlus and the Future

The solution to problem B embodied in MVOPLUS may be used as an

optimization tool for the future. The process may be conceptualized in
two different ways:

Deterministic Viewpoint

In this picture, the user makes forecasts of the geometric mean,

standard deviation and correlation matrix for some specified range of
periods in the future, and the output of MVOPLUS, in particular the
Geometric Mean Frontier, is that which would obtain if these forecasts
turned out to be correct. In this viewpoint, the future is conceptualized in
precisely the same way as the past.

Statistical Viewpoint

This picture is more similar to the conventional single period one. The
user assumes that the different periods in the future are independent
and identically distributed according to the specified inputs. Under this
hypothesis, the interpretation of the geometric mean which is assigned
to each rebalanced portfolio is that it is both the most probable return
and the median return which would be obtained over a large number of
periods.
Although these two viewpoints are conceptually rather different, the
methodology for computing the Geometric Mean Frontier is the same in
both cases, and the outputs of MvoPlus may be viewed in either way.

MvoPlus and Historical Data

When used with full historical data, MVOPLUS operates in a slightly

different way, called DATA mode, which combines the features of a
mean variance optimizer and a back-tester of historical data.

First, the input data for Problem C are generated from the historical
data, and the Arithmetic Mean Frontier is computed. The geometric
mean of each portfolio on the frontier is then computed exactly using the
historical data; this yields the Geometric Mean Frontier.

This approach again uses the fact that the portfolios which optimize the
rebalanced geometric mean are, to a good approximation, the same as
those which optimize the geometric mean, but provides a more accurate
solution to Problem A than using the approximation between the
geometric and arithmetic mean to compute the Geometric Mean
Frontier.

4. Which Product is Right for You?

Single Period - VisualMvo

VisualMvo provides an implementation of the classical single period

MVO algorithm. You should consider VISUALMVO if either of the following
applies:

• You are content with the conventional single period treatment.

• You make your own predictions of the MVO input data based on
your beliefs about the short term future, and these beliefs are
such that your inputs vary considerably from one period to the
next. In this case, the constant proportion rebalancing feature of
MVOPLUS may not be of interest to you.

Multi-Period - MvoPlus

MvoPlus has all the features of VISUALMVO, plus the ability to optimize for
multi-period geometric mean return of rebalanced portfolios. It also
functions as a back-tester and approximate optimizer of historical data.
You should consider MVOPLUS if any of the following apply:

• You would like a versatile portfolio optimization tool which is

capable of solving a variety of portfolio optimization problems
involving either the geometric or arithmetic mean.
• You do not believe it is possible to make meaningful estimates of
the properties of a single upcoming period, but believe that over
multiple periods more reliable estimates may be made.
• You intend to use historical data as MVO inputs.

5. References
[1] Markowitz, Harry M., Portfolio Selection, second edition, Blackwell
(1991).

[2] Bernstein, William J. and Wilkinson, David, Diversification,

Rebalancing and the Geometric Mean Frontier, research manuscript
(November 1997).